Efficient markets (addendum)

You never gave a method of capital allocation that is better than free markets. I understand your point about circuit-breakers, gradual deregulation, automatic stabilizers, etc. But all of those things go along with a market system. The free lunch is still there, you just want to filter the information that comes out of it. I guess the only other way to take your post would be that you’re in favor of a completely planned economy, which would be pretty disappointing considering you cite the case of China, a country that has succeded precisely because it opened its markets.

Surowiecki’s point still stands, the market is the thing, its just a matter of protecting from its few cases of irrationality.

I don’t mean to turn this into a discussion of my book, or anticipate Daniel’s forthcoming demolition of my work, but I do think that saying I believe unfettered asset markets to be uncluttered founts of wisdom is a radical misreading of “The Wisdom of Crowds.” When I write that there are stretches “when markets are indisputably ruled by emotion and are systematically wrong,” that they’re “fertile ground for speculation,” and when I quote Keynes — wrongly, as I now know, thanks to John — about markets ability to stay wrong longer than you can stay solvent, I mean what I say. “[F]inancial markets are decidedly imperfect at tapping into collective wisdom, especially relative to other methods of doing so,” is what I wrote in the book, and what I still think now. And I’m hardly opposed, in principle, to the careful sequencing of deregulation or regulation of institutional development (though I think the planners working on these would do well to rely on collective decision-making techniques rather than concentrating power in the hands of one or two decisionmakers).

Having said all that, I don’t think it’ll do to just say that “planning” is necessary “when free market solutions appear to be delivering a destructive or irrational allocation.” We need to know how the planning should be done — I, for instance, would have a lot more confidence in it if it reflected the collective judgment of a diverse, independent crowd of analysts and thinkers rather than being made by an individual — and we need to know what the theoretical justification is for thinking that it will be done better. The examples of China, Malaysia, and Chile are interesting, but hardly definitive. And the record of banks in lending to the Third World — to say nothing of the historical record in the US of speculative bubbles and panics in bank lending — don’t exactly inspire confidence in the ability of a few supposedly well-informed planners (if you think of individual bankers making loans as analogous to planners allocating capital) to consistently make intelligent decisions.

To my mind, the choice has never been between “unfettered free markets” and “free markets plus planning” (which seems to be roughly Daniel’s choice). (The simple fact that currency values are set, in large part, by governmental decisions means that planning is integral to today’s markets.) The job is figuring out the right balance between markets, regulations, and state intervention, and that’s a balance that will be different in different situations. (I don’t, for instance, think the US government should spend much time worrying about how the US stock market values companies.) I think this thing I call the wisdom of crowds can be of use in making all three of those phenomena work better, but the right conditions have to be in place for that to happen.

Finally, figuring out the proper allocation of capital, etc., is much much harder than brain surgery.

Indonesia.

In fact, in general I submit the natural experiment of the 1997-99 Southeast Asian crisis. Countries involved in that crises did better or worse depending on how quickly and how thoroughly they disengaged from the market.

I would also teasingly ask exactly where one might go to find a large crowd of informed, independent analysts to answer the question of whether Malaysia should have capital controls. Everyone in the crowd had an iron in the fire; there was simply nobody whose main concern was the Malaysian economy apart from Ibrahim and Mahathir.

Re:

Which is why the academics who are still driving stakes into the heart of the efficient markets theory are doing vital work

would you, for the benefit of the civilians present, cite a few specific examples?

James: I’ve always thought you were a terrific writer, and I was sorry when you left Slate. But I’m having trouble figuring out what the thesis of your book is. Since no one is suggesting that the US abandon capital markets completely, and since you’ve already conceded Daniel’s main point (capital markets can require government intervention in reaction to crises), I’m not sure what you’re arguing against.

I’m specifically arguing against the proposition that it is not possible for a well-informed individual to know better than the markets whether the market is proposing a capital allocation that makes sense (or more weakly, that this does not happen often enough to be worth making the basis of policy). I believe that this proposition is false, and that blind faith in the belief that it is true has been extremely damaging.

… Indonesia as a control group to China in the post-1978 period? Doug M’s on vacation, but hell, even I can think of six different reasons why that makes no sense at all.

I’m specifically arguing against the proposition that it is not possible for a well-informed individual to know better than the markets whether the market is proposing a capital allocation that makes sense (or more weakly, that this does not happen often enough to be worth making the basis of policy).

Has anyone ever really believed this? I know that people have claimed to believe it, with the aforementioned disastrous consequences, but aren’t there better (and more elegant) explanations that center around the concept of ideology or the ignoble lie, for example?

“China has succeeded precisely because it has opened some of its markets, gradually, on its own terms.”

Isn’t it a bit early to say that China has succeeded? It still has a long way to go, and could blow up at any time (taking Taiwan with it). It has done remarkably little about state-owned enterprises, it has manufactured its own AIDS crisis, and the mishandling of the SARS epidemic should show some gaps in its ability to handle problems through planning.

China has come a long way, partly because the Chinese Communist Party first had the foresight to beat the economy to shreds for years, making quick growth off the bottom more feasible. But if you’ve watched the details of the development of the Chinese economy, China is, if anything, an example of how markets can take off and help a country grow in spite of the interference of government.

Keep in mind, we need to consider the various types of regulation. US securities markets have been relatively efficient because regulation has focused on providing sufficient information for investors to make their own decisions. Many countries have instead tried to protect investors by pre-screening companies, thus letting government bureaucrats pick the winners and losers. This tends to be vastly inefficient, as well as an invitation for corruption.

So, it depends on what type of “planning” you’re talking about. If it’s the Chinese Communist Party type, it’s not going to help.

I submit the natural experiment of the 1997-99 Southeast Asian crisis. Countries involved in that crises did better or worse depending on how quickly and how thoroughly they disengaged from the market.

How did you arrive at this conclusion? By what metric?

My recollection is that Malaysia’s performance was neither better nor worse than most of the other affected countries. It’s true that Malaysia suffered less than Indonesia, but so did every other country during the crisis.

Indonesia’s unbelievable corrupt-monopoly-rampant pre-1998 economy not a great example of being engaged with the market.

Walt, the book’s thesis is simply that under the right circumstances, groups are very smart, and are often smarter than even the smartest person in them. It’s not really an argument for markets vs. planners (most of the book is not about markets per se), so much as it is a general argument for relying on collective judgments — which are the product of aggregating lots of individual, independent judgments — rather than relying on a single expert. Markets are one way of reaching those collective judgments, but to answer Jonathan’s question there are other methods that work very well: parimutuel pools, the algorithm Google uses to aggregate the judgment of Web sites, and even simple schemes that aggregate numerical forecasts. Regardless, I think the evidence is overwhelming that over time, relying on the collective judgment of a group of people working to solve the same problem will maximize your chances of getting the right answer — or picking the best option from among a set of choices.

I don’t write about development in the book, or about capital crises in any great detail, but one of the obvious problems with most asset markets (and the reason I say that they’re decidedly imperfect), is that not everyone in them is really working on the same problem, which is to say that not everyone is really trying to forecast the net present value of all the potential investments. (Some people are momentum trading, some are just herding in order not to get left behind, some are simply speculating, etc.) This is in contrast to, say, bettors at the racetrack, where every bettor really is trying to predict the chances of victory of the different horses. For this reason and others — there’s no definitive outcome in most asset markets, as opposed to the track — asset markets are far more volatile and less reliable.

On the other hand, I think there is little evidence that individual politicians or policymakers are going to consistently offer better judgments about net present value, either. So I don’t think simply invoking planning as a solution is enough.

…when a capital allocation is making sense…

This whole line of resoning is making no sense. Making sense to whom? Compare to what?

So far a couple things seem to have been demonstrated empirically:
1. an unregulated market system will relatively quickly self-destruct and
2. a centrally-controlled system will eventually self-destruct although, apparently, not that quickly.

Well – doh. This is quite trivial. Obviously a hybrid is going to be more stable and effective than any extreme. What kind of hybrid – it depends on a particular economy.

The US economy (especially the hi-tech and pharma) is, actually, highly centralized: most of the R&D (which is really the heart of it) is financed and managed by the government, mostly via the Pentagon.

When I say daily operations I mean micro-managing the market. I realize that on certain days somebody is going to come in and propose a solution. That doesn’t mean that every day there should be some change forced on capital allocation by outsiders. You still haven’t proposed a system better than capital markets, only a bunch of ad hoc patches.

I think the most telling bit of evidence about the superiority of unfettered free markets is the total support that large corporations have for them. ADM is the paradigmatic American example.

This is sarcasm, right? Price-fixing ADM – heh, heh. Good one.

Just a point on the focus on US stock markets. The stock market is not the most interesting case of the EMH in policy terms, but it’s excellent for testing, since the conditions for EMH are met as closely as its possible to imagine a market meeting them.

There are large numbers of participants, markets are liquid on every time-scale from seconds to years, there’s a strong legal framework, no significant government trading activity, long-established and highly-sophisticated financial institutions and so on. If EMH fails here, it fails everywhere.

Jonathan, if you want examples of academics driving stakes into the heart of the EMH, a good place to start is Robert Shiller’s book Irrational Exuberance.

James: I see. I hope no one would really disagree with your thesis. :-) Another example would be democracy itself. I know lots of people who believe that a benevolent dictator would provide a better government than a democracy, but unless that dictator is omniscient as well, there’s no way that the dictator will be able to match the information-processing ability of a democracy.

Ian: Three unrelated comments:

1. Daniel isn’t proposing an alternate system, he’s trying to kill off the efficient market hypothesis. The EMT is not just a claim that capital markets are a better method of capital allocation, but a _perfect_ method.

Also, didn’t Japan initially protect its fledging industries from foreign competition? (It’s been so long that I don’t remember.)

Chun: Some people really did believe the EMT. While I’m sure that there was an ideological component, the theory itself fairly seductive in its full mathematical glory.

Having said all that, I agree with Daniel’s points 4 and 5, although I would replace “policymaker” with “group of policymakers.”It seems to me that the real challenges are figuring out how to maximize the chances that the “policymaker” is sensible (relying on the collective judgment of government analysts and policymakers rather than the judgment of a single politican would help), as well as how to guarantee that interventions during times when markets are, in Daniel’s sense, failing don’t become justifications for interventions in the everyday process of allocating capital.

Isn’t the debate really about whether markets are efficient under all conditions?

A further point.

And doesn’t the good Mr. Surowiecki, bless his heart, admit that his thesis is based on certain conditions being in place?

Well then, I’m glad we all agree.

South Korea and Japan had a “substantial state presence”, but is that what made them succeed? Look at Japan – the strong, successful industries are those that faced foreign competition (through exporting). Industries that have been sheltered (banking, retail, etc.) are pathetic. Japanese and South Koreans have recognised for more than a decade that they need to get away from state guidance of investment (although they’re having a hard time actually doing it). Taiwan, on the other hand, has many strong, dynamic medium-size companies, rather than a few behemoths.

One problem with Daniel’s points 4 and 5 is that there’s no guarantee that decisions will be made by a “sensible” policymaker. The democracy/dictatorship comparison is good. Everyone points to Singapore as an example that strong government control can work well. But for every Lee Kuan Yew, there are far too many Ferdinand Marcoses, Robert Mugabes and Mohamed Suhartos. To compare government control to regulated markets, we have to factor in the probability that decision makers will be affected by greed, stupidity and/or laziness.

One way to think of it is in terms of diversification. Markets sometimes fall victim to herd mentality, but even then there are some looking to profit from the mistakes of others – enough of them will stop the market from going too far in the wrong direction. With central control, there’s a risk that the entire system will go horribly wrong.

Think of what Mao accomplished – during the Great Leap Forward, he managed to bring famine to all of China, Tibet and Xinjiang at once. There had long been periodic famines in China (although there had been amazingly few in Tibet), but to impose disaster on all corners of such a huge, geographically-diverse area at one time was an unprecedented feat, one that would have been impossible if markets had been allowed to function.

James says: _The job is figuring out the right balance between markets, regulations, and state intervention, and that’s a balance that will be different in different situations._

Now who could disagree with the above tautological proposition? (No sir I want the WRONG balance!) It makes you wonder why the debate exists at all.

The right balance = the devil is in the detail.

Let’s take a specific example (one among 000s): WTO rules will allow the market to rule which means large efficient companies, will extinguish smaller companies. Many large companies are being run for the interests of a minority of the world’s population (although more may benefit indirectly). THEREFORE WTO liberalisation potentially means a polarising of power in the hands of a few: Open market leads to increasing inequality – capital income share up, labour income share down.

A refusal to accept that any planned or managed approach could work is ideologically attractive to those with most of the money! Who is that?

q – nearly everything you say about the WTO is dodgy, starting with the idea that WTO rules allow the market to rule.

It is not hard to make many abstract arguments for planning. Nearly the entire economics profession fell for this in the early 20th century. The problem is identifying exactly what this new government institution is going to do and how you’re going to ensure it does a better job. If you had the option of creating a government body that only made the right choices… then fine. Can somebody please name such a government body?

” …As in the California energy farce a few years ago.” That of course wasn’t the stock market but a new-fangled commodities market. So I think John is right in his reasons for focusing on stock markets.

Somebody’s already said it, but I’ll repeat it since it’s my view as well. Discrediting the EMT is easy because it’s making a universal claim and needs the world to be perfect in order to be true; it’s saying that in all cases this is what happens. And, under all versions of the thesis (strong, semi-weak, weak…), there are cases when it doesn’t hold. The world’s not perfect.

On the other hand that doesn’t invalidate the use of markets, because they might still be better than the alternative. Planners sometimes get it wrong; they sometimes get it right, of course, but they can be wrong. Choosing one data point (look at China!) hardly advances the issue. China may have been lucky rather than good.

Krugman might have been right about the Asian markets, but that doesn’t mean that he will be right the next time. To finish as tangentially as possible, my impression of Krugman is that he sometimes makes predictions which are opposites – e.g. (from my perspective anyway) predicting one week there will be deflation and the next week that there will be inflation; this way it’s easy always to be right. So I think before we crown King Krugman, I’d prefer to see the historical record of everything he wrote in the Asian period, and not just items selected post hoc.

As it happens, I was just thinking about posting on EMH and the energy farce and will now get moving on it.

if you want examples of academics driving stakes into the heart of the EMH, a good place to start is Robert Shiller’s book Irrational Exuberance.

And if you want a rather less academic, but entertaining example, try Edward Chancellor’s Devil Take the Hindmost.

Quant à moi, and limited to the stock markets, the EMH is, for all its occasional failures and for all the legitimate caveats one can raise, in its weak to semi-strong form a pretty useful working assumption (so long as one also assumes an adequately liquid stock that receives adequate coverage by analysts).

It’s not the Law of Gravity. But it does lend gravity to the law: it is the theoretical underpinning of the fraud-on-the-market concept. Let us say that I hold shares in a mining company (indeed, let us say it is a company rather like this one). The company has just discovered that it owns a massive and valuable deposit of copper. As rumours of the find begin to spread, the company states publicly (and in bad faith) that, no, there is no copper here. The share plummets. I sell – but not because I have been following the copper story; I simply looked at the price, thought the stock a dog, and decided to get out. A week later, the company says, hang on, we do have a lot of copper. The share takes off, which would make me very happy, if only I had not sold at the lower price. It is the fraud-on-the-market theory that gives me a cause of action. And it does so because it assumes, under less-than-strong EMH, that the market will quickly build all publicly-available information (including, in this case, false information, and hence the fraud) into the price of (adequately liquid, adequately covered) shares. If this is the case, then I am a victim of the fraud even though my decision to sell was not made on the basis of the false denial of the copper deposit. That the shares of the mining company did not rise despite the company’s initial denial of a new copper deposit suggests that strong-form EMH is bollocks; that the share fell after the first statement and rose upon the second suggests that less-than-strong EMH is not.

Some in this comments thread have suggested that a general acceptance of EMH serves the interests of Big Evil Corporations, and so BECs take pains to see that it remains accepted. EMH certainly doesn’t always serve the interests of BECs that are publicly traded and subject to American securities laws.(1) If it is the BECs that are behind all this, then what I would expect to see is a huge effort by BECs and their lickspittle hirelings to make EMH, and with it the fraud-on-the-market theory, go away. I’m not certain one can say this has happened.

(1) More precisely, the interests of the BEC’s management. What the ‘true’ interests of a firm are, and whether they can or should be anything other than the aggregate interest of its shareholders, is a question for another day.

Daniel writes:

I happen to have a vague friend-of-friend connection to someone who claims to have brought the first ever “fraud on the market” claim in a US Court and even he admits it’s the most appalling blag.

Yes, well; litigator, innit? His approach is, ehh, doubtless pragmatic rather than theoretical, and fair play to him, given his job.

That said: the facts in Texas Gulf Sulphur make for a plausible argument that it is not appalling blag; as do those in a good many other cases. (I should note that I carry no professional brief for the FotM theory. I am not a litigator at all, and those of my colleagues who are would be on the other side of the room from the friend of your friend. Usual disclaimers, etc.)

That’s not necessarily a fair test, Andrew. Drawing some pretty general conclusions about the application of the EMH and the effects of that in terms of booms and busts, is not the same as being able to reliably predict the relative economic performance of two pairs of countries over a period of just two years.

In other words, there are a lot of factors involved; the effects of shorter-term trends may temporarily overshadow the effects of longer-term trends; etc. etc.

Really, one can’t point to a couple of pairs of different countries over a short period of time and then shout triumhantly “That demonstrates that my policy prescriptions are correct!” (as many capitalist cheerleaders did over the case of the Asian Tigers when they were apparently doing so well). However, when essentially the same policy prescriptions are enforced by lending institutions over and over and over again, with similar disastrous results over and over again… then I think there is cause for drawing some tentative conclusions, don’t you?

Um, since when did the efficient markets hypoethesis require that countries hold fixed exchange rates (Argentina, Thailand, and recently Turkey), or for California to decree that the elasticity of demand for electricity be zero above a certain price? I think that we have to clearly separate this hypothesis from policy mistakes made in the name of partial liberalization. Of course the EMH can’t be completely true but when it isn’t, using this as an excuse to justify an unrelated policy just doesn’t make sense. X implying Y does not imply that not X implies not Y.

Ann wrote:
South Korea and Japan had a “substantial state presence”, but is that what made them succeed? Look at Japan – the strong, successful industries are those that faced foreign competition (through exporting). Industries that have been sheltered (banking, retail, etc.) are pathetic.

Porter and Sakakibara document this (for Japan) in a recent Journal of Economic Perspectives article.

A bit off-topic, perhaps:

I’m more interested in discussing, not EMH in isolation, but also EMH as part of overall macro-economic theory. If strong-form EMH is implausible, what conversely does that imply for general equilibrium theory, for instance?

My intuition (perhaps off-base) is that the economics community so quickly and enthusiastically latched on to EMH is that EMH validated much of the previous theoretical work in other topics. Perhaps even to the point of proving the entire superstructure – after all, finally, the economists had one actual market that could be called efficient. Essentially, that if Fama hadn’t done the initial study, someone else would have – and the pressure would have been to declare EMH valid rather than invalid.

I have always thought these arguments go on at way too high a level of generalization. I am both an academic and a former bond trader. Here is what I am convinced of:

SOME markets work efficiently. SOME markets dont. Evidence can be found in various liberalization exercises, where once you get rid of all the controls and regulations the true structure of the market is revealed. Some (few)resemble textbook atomistic markets. Some are oligopolies. Some are monopolies. Some involve public goods and will NEVER function efficiently with optimal capital allocation on their own.

Even as a bond trader I found that at times the market didnt work all that well. That’s why I could make buckets of money exploiting peculiarities of market structure even there. But most of the time it functioned just like the book said.

There is NO ONE ANSWER. And a good thing too, or we economists would be out of a job.

I have a question that I hope somebody can easily answer, as this whole debate has been very interesting and I’m a complete economics dilettante.

I just finished reading Stiglitz’s book Globalization and its Discontents. It seems to me that one of his major points, specifically regarding the East Asian crisis, was that the IMF was giving the countries who were willing to follow its prescription huge loans, which were used primarily to prop up the value of the currency, which allowed foreign investors to pull out more of their money than they would have had the IMF not interfered. This policy was obviously tilted in favor of creditors rather than debtors and allowed creditors to skate on their risk analysis, assuming that they’d get paid back if they made bad investments.

Why is this seen as an unfettered free market? Isn’t the IMF itself guilty of planning? Why is this seen as a failure of the market rather than a failure of the IMF’s bad planning?